OPEC decision: Good news from the oil cartel gives government time to consider options

The decision by oil cartel OPEC to increase the supply of crude oil was more or less expected. But the uncertainty was on the stance that major producer Iran would take as it has veto powers. The fact that the 14 nations along with Russia have agreed to increase output by one million barrels a day is a positive sign for the world economy, as it will help, in due course of time, bring down crude oil prices to the median level.

It can be said that if such an agreement was not reached the prices of oil would have increased to a new high mean. Now, one can hope for a range of $70-75 a barrel to be the new norm.

The decision to increase output by one million barrels should be looked at with circumspection. First, while the decision has been taken to increase output it has not been stated as to how it would be distributed. Second, while the number of one million looks reasonable to begin with, it is generally expected that given the capacity constraints the actual increase could be 700,000-800,000 barrels. Third, the output hike is actually less than the 1.8 million cut that was implemented in 2016 when prices came down sharply.

Representational image. Reuters.

Also, while the 1.8 million cut was the decision taken, given production issues in Venezuela, Libya and Angola, the actual decline was estimated to be closer to 2.8 million. Against this background the one million hike could be called a token measure by OPEC that will now gauge the market. The point is that in terms of world supply, the output would still not be at the normal level.

Should the world market be happy? The answer is yes because an increase in supply was required or else the global economy would get affected by higher inflation everywhere, leading to proactive monetary policies that in turn would come in the way of investment at a time when things seem to be looking up.

While this decision is still short of making up for the past decline in oil production, there is apprehension of how this would pan out; and the politics surrounding Iran still remains the joker in the pack. Any escalation in tension here could lead to adverse reactions in the oil economy.

What does this mean for India?

Any measure that leads to the international price of oil coming down is good news for us as it lowers the import bill and the current account deficit (CAD), cools inflation, puts less pressure on the fiscal balance sheet and in a way defers any further rate hike action from the Reserve Bank of India (RBI).

The exact magnitude can be judged after a period of a month when the price of oil stabilises. Presently it may be expected to range between $77-75, which is still higher than the $65-70 bracket expected for the economy at the start of the financial year. This will be the driving force for the impact on various economic variables.

The interesting question is as to what the government would do on taxes. It has been argued that when the price of oil came to the $40/bbl range, the consumer never paid a commensurate lower price and the government raked in the extra revenue. When the price had crossed $ 80/bbl there was a call to lower taxes, which did not find favour for the same reason as it would have dented the fiscal arithmetic.

The government did take a chance that the high price would not be sustained and hence waited for a correction of oil prices, which probably will take place now that OPEC has sent an announcement that effect. In a way, the government’s stance of not taking action stands vindicated as that particular phase in May was a temporary one.

Central duties are specific while state VAT is ad valorem and hence the central government may not really lower rates that are based on output. States will have to take their individual calls on the subject. But it may be surmised that there will be a tendency to lower the prices of petrol and diesel as there are several state elections from here on till the general elections, in early 2019. This will hold more so in states that are going in for elections, where the price of petrol and diesel could influence voter decisions.

But at a policy level a call has to be taken on whether or not to include petrol and diesel under the Goods and Services Tax (GST). This is critical because price volatility in oil is here to stay and the threat on various economic variables will linger in the background. Ideally the rates should be taken towards the higher limit of 28 percent, or in the extreme situation could be a new rate that remains fixed. This will bring more certainty and also be palatable.

Oil economics will continue to dominate the canvas for this year as several developments in the global space especially the trade wars are playing out. The Indian government has to monitor these developments regularly and pick up signals relating to the prices of oil. Decisions on taxation would have to be taken and the present relief provided by OPEC should be leveraged to take a concerted view.

(The writer, chief economist, CARE Ratings, is author of 'Economics of India: How to Fool all people for all times')